NOT EXACTLY

THI.N.5.1.06. FINAL 4/17/06 10:29 AM Page 2 CAROL GWINN
NOT EXACTLY
COUNT E
MOST BIG BRANDS DON’T WANT TO
TALK ABOUT IT, BUT THERE’S A BUG IN
THE OUTSOURCED ECONOMY: FOREIGN
CONTRACTORS MAKE MORE PRODUCTS THAN
THEY’RE SUPPOSED TO, THEN SELL THE
EXCESS OUT THE BACK DOOR. NEW BALANCE
FOUND OUT JUST HOW HARD IT CAN BE TO SHUT
DOWN THE “THIRD SHIFT.” BY ROGER PARLOFF
GEE, COUNTERFEIT PRODUCTS ARE GETTING SO REALISTIC!
Doubtless you’ve heard some version of that comment in recent
years. Well, they are getting more realistic, for two reasons. One you
know about, but one you might not.
The prong of the problem everyone understands is that technologi-
cal advances in printing, scanning, 3-D modeling, and so on have made
copying through reverse-engineering easier and cheaper than ever. And
if you ask any brand owner why counterfeits are so convincing these
days, that’s the answer you’ll get.
But there’s another factor. Now that Western companies are perva-
sively outsourcing the manufacture of their products to factories over-
seas, they’re entrusting their precious intellectual property—designs,
molds, specifications, trade secrets—to hundreds of contractors and
subcontractors all over the world.
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T ERFEIT
New Balance ordered
Chinese contractor
Horace Chang to stop
making and selling the
“classic” shoe (far left) in
1999. He refused. It’s
still on sale in Shanghai.
The Henkee (near left)
is a competing brand
that Chang launched
when relations with
New Balance soured.
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THIRD SHIFT
It’s extremely hard to police global supply chains, and IP is leak-
ing out through 1,000 cracks.
The simplest and most dramatic form of the problem is some-
thing that Asia-based investigators jocularly refer to as the “third
BRAND RIPOFFS:
shift,” the “midnight shift,” or the “ghost shift.” Say a U.S. com-
pany orders 20,000 dresses from an overseas factory. The con-
A USER’S GUIDE
tractor fills the order during its two day shifts but then runs off COUNTERFEIT A product that bears a trademark
10,000 extra at night, possibly using inferior materials. Those he that its maker had no authority to use.
sells out the back door, so to speak, trademark and all. In the
case of apparel, says Vincent Volpi, the head of PICA, a brand- KNOCKOFF A broad term encompassing both coun-
protection firm, third-shift products may be “substantially indis- terfeits and items that look like branded products though
tinguishable, down to the same thread count.” they don’t actually bear forged trademarks.
Daniel C.K. Chow, an IP-law professor at Ohio State Univer-
sity, recalls his own former employer, a multinational consumer- THIRD SHIFT An unauthorized product made by
brands company he declines to name, having a third-shift prob- an authorized contractor.
lem at a factory in China that produced packaging and labels.
The contractor “would sell the night shift to counterfeiters,” says
Chow. “You’d wind up discovering a counterfeit product in a
genuine package.”
Sometimes even brand owners can’t tell whether an unauthorized
product is a counterfeit (a product bearing a trademark that its maker
never had authority to use) or the result of third-shift activity. In late
2001, for instance, Too Inc., which runs the Limited Too chain of
clothing stores for girls, discovered that discounter TJ Maxx was sell-
ing 31 styles of Limited Too apparel at markdowns—653,000 gar-
ments. TJ Maxx was stocking many more units than Too had ever
ordered from its Asian suppliers, and what Too had ordered was still
being sold in its own stores. When Too sued TJ Maxx to stop sales,
though, its lawyers candidly admitted that they weren’t sure whether
the clothes were counterfeits or third-shift goods. Though discoun-
ters can always be enjoined from selling counterfeits, some judges
will let them sell third-shift goods unimpeded, viewing the latter as
legally “genuine.” In Too’s case, the judge enjoined the sales, ruling
that even third-shift goods were a form of trademark infringement,
albeit less serious than counterfeiting. That seems to be the emerg-
ing view. (The case settled in 2003.)
IN ADDITION TO literal night-shift activity, the “third shift” is an
umbrella term for any form of unauthorized production by oth-
erwise authorized contractors. A common variant arises when a
brand owner tells an overseas contractor to stop producing a line In Shanghai real New Balance shoes are sold alongside
of product, and the contractor doesn’t. “You’ve taught a company Henkees, a lawful knockoff made by a former supplier.
to produce something,” says one China-based investigator who
requested anonymity, “and perhaps that’s all those people know
how to do. Just because you have agreements doesn’t mean those
people are going to stop doing what they’ve learned.” ner sell its technology to rivals. Within four months counterfeit
Even in its wider sense, the third shift is a subset of a broader prob- Yamahas were being sold, Deng says, and by the early part of
lem: the countless ways in which companies lose control of intellec- this decade, five of six Yamahas in China were counterfeit.
tual property when relying on an outsourced supply chain. IP leak- When this sort of IP theft is thrown into the mix, the bound-
age is the glitch in the ascendant paradigm for doing business. ary between third-shift goods and counterfeits begins to melt
“When you’re outsourcing, you provide specifications, draw- away. “When a brand owner shuts down a factory,” explains Jef-
ings, blueprints,” says Peter Humphrey, who runs a risk-manage- frey Unger, CEO of GenuOne, a brand-protection management
ment firm in Shanghai called ChinaWhys. “What can easily hap- firm, “you’ll see the same factory start up two months later mak-
pen is, someone takes it down the road to his brother or uncle,” ing counterfeit product. They know where to buy the raw mate-
who also has a factory. “Before you know it, there’s ten or 20 fac- rials and know how to move product.”
tories in that county making knockoffs of your product.” In the Variations on that theme now challenge the multinational chem-
mid-1990s, according to Ping Deng, a professor of business ad- ical, pharmaceutical, and information technology companies that
ministration at Maryville University in St. Louis, Yamaha set up have spent billions to set up R&D facilities in China, lured by
three motorbike joint ventures in China, only to have a local part- the 600,000 Chinese engineers its universities graduate each year.
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THIRD SHIFT
A disloyal engineer can steal a gigabyte of proprietary informa- companies have avoided that path for fear of either publicizing
tion by saving it to a tiny USB flash drive, according to Humphrey their own mistakes or alienating local officials with whom they’ll
of ChinaWhys. In one of Humphrey’s cases, he says, an employee be dealing. But New Balance chose to fight. Other brand owners
stole a new industrial process for manufacturing a chemical and can learn much from its eye-popping experience.
then started a competing business in collusion with his former em-
ployer’s suppliers and customers. In another, research on nano- FROM A SEVENTH-FLOOR picture window at New Balance head-
technology was stolen. “In the cases I’ve dealt with, the crimi- quarters in Boston’s Brighton section, the concrete horseshoe of
nals are people with Ph.D.s,” says Humphrey. Harvard Stadium looms to the northeast, while stately Baker Li-
Brand owners typically don’t admit to having suffered from brary of Harvard Business School commands the view due east.
third-shift or other IP-leakage problems. “It makes you seem like Yet the most noteworthy landmark lies just out of sight, about a
you’ve been an idiot,” explains professor Chow. “These are peo- mile to the west. There stands a rarity: a functioning American
shoe factory.
Executives at New Balance, a private company celebrating its
IP LEAKAGE IS THE 100th anniversary this year, are proud to own that plant and four
GLITCH IN THE others in New England. They still produce 25% of the com-
pany’s footwear. But tradition and patriotism carry a company
NOW-ASCENDANT only so far: New Balance, which reported $1.54 billion in sales last
year, competes in the same world as everyone else. About 70% of
PARADIGM FOR DOING its shoes are now made in China, and the other 5% in Vietnam.
New Balance began outsourcing in the early 1980s, using fac-
BUSINESS. tories in Japan, then South Korea, then Taiwan. In the early 1990s
its Taiwanese suppliers began moving their factories to mainland
MAGNUM PHOTOS
China. One of those contractors was Horace Chang, now 59, a
tough, keen businessman. (Chang declined to be interviewed for
this article, citing New Balance’s legal proceedings against him.)
In 1990, Chang built a factory in Yang Jiang City, in Guangdong
province near Hong Kong. At first his factory, which can employ
up to 4,000 workers, made New Balance shoes only for export. But
in January 1995, at Chang’s request, New Balance licensed him
to also distribute its shoes to the Chinese domestic market.
Chang’s sales were initially modest, according to Ed Haddad,
57, New Balance’s vice president for intellectual property. But soon
he had success with an inexpensive style known as a “classic.”
It’s a colorful fashion shoe with “no technology,” Haddad ex-
plains—meaning none of the fancy midsole engineering that de-
fines a high-performance shoe. In June 1999, Chang stunned New
Balance executives at a meeting in Boston by announcing that
he was projecting sales of 250,000 pairs that year—quadruple what
he’d sold the year before.
“We were amazed,” recalls Haddad. But not pleased. New Bal-
ance executives feared that the company’s name was becoming
associated in China with a fashion shoe, jeopardizing its reputa-
tion as a performance brand. They told Chang to pull back from
selling classics. “He was dumbfounded,” Haddad recalls. “He
came here thinking he was doing a great thing—like the cat that
brings you the dead mouse—and we slapped him on the hand.”
Chang didn’t pull back. Rather, he ordered materials to pro-
duce 450,000 pairs, as the New Balance sourcing department re-
ported to its alarmed management later that year. Soon Chang’s
inexpensive shoe was seeping out of China into premium mar-
IP chief Ed Haddad urges companies to monitor their supply chains. kets like Japan. Licensed New Balance distributors there were
furious. In August 1999, New Balance notified Chang that it was
ple you’ve hired. You didn’t exercise due diligence.” Most terminating his license to make and distribute classics, effective
brand owners approached for this story either declined to dis- Dec. 31, 1999.
cuss the issue or denied experiencing the problem. “What happened then is when everything went crazy,” Haddad
There is, nonetheless, one brave Western company that has recounts. Upon termination, the contract called for Chang to re-
come out of the closet about its struggles with the third shift. When turn to New Balance all its confidential technical, production,
New Balance thought it had been wronged by a former contrac- sales, and marketing information, including molds, specifications,
tor in China, it decided to litigate in the Chinese courts. Many signs, labels, packages, wrappers, and ads. He didn’t.
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THIRD SHIFT
“He continued to sell,” says Haddad, “and was actively trying former military or police officials. Judges outnumber lawyers in
to sell product outside the country: in Taiwan, Hong Kong, Italy, China 200,000 to 140,000.
Germany.” (It’s unclear whether Chang continued to make clas- More important, even legally trained judges have scant judicial
sics after 1999 or sold stockpiled inventory. Chang told the Wall independence, according to Jerome Cohen, a law professor at New
Street Journal in late 2002, when it wrote about the situation, that York University and a renowned authority on the Chinese legal sys-
he still considered himself entitled to make New Balance shoes.) tem. “They are under political control,” he says. “Judges are se-
At New Balance’s request, the provincial divisions of China’s lected locally, paid locally, promoted locally, and fired locally. A for-
Administration of Industry and Commerce (AIC) seized about eign company—or even a Chinese company from another part of
100,000 pairs of Chang’s shoes from his stores and factories. Dur- China—going up against a locally owned enterprise has an uphill
ing one raid New Balance made an alarming discovery: Chang fight.” Plus, Cohen adds, “corruption is a very serious problem.”
had launched a competing line of classic-style sneakers under Lewin understood that since New Balance was trying to enforce
his own brand. These he called Henkees (a meaningless word Chang’s contract termination—potentially costing local factory
in Chinese), and he marked them with a
logo on the saddle that purported to be MAGNUM PHOTOS
a distortion of “Hi.” At a glance it looked
a lot like New Balance’s block N saddle
design. Chang had obtained a Chinese
trademark on the Hi logo without New
Balance’s noticing.
Like most Western companies doing
business in Asia, New Balance had in-
serted arbitration clauses in its contracts
so that it wouldn’t have to deal with for-
eign courts. Disputes were to be heard by
an international arbiter applying Massa-
chusetts law. But while an arbiter could as-
sess damages, he could not provide New
Balance what it needed in this crisis: an in-
junction stopping Chang from selling New
Balance classics. To get that, the company
had to sue in the Shenzhen Intermediate
People’s Court for Guangdong province.
In late 2000 it did.
To oversee the litigation the company
retained Harley Lewin, an IP litigator at
New York City’s Greenberg Traurig. A
barrel-chested man with a trim white
beard, Lewin decorates his office with
trophies from past assignments: a gor-
geous leather Chloé handbag, buttery but Litigator Harley Lewin has overseen intellectual-property suits in 45 countries over 30 years.
bogus; a bottle of Pure Vodka that mim-
ics an Absolut bottle’s design; a phony Titleist golf ball. “I’ve workers their jobs—he was up against it. Still, when the Shenzhen
tried cases in 45 countries over 30 years,” he says. “I sit there court handed Chang a sweeping victory in February 2002, Lew-
next to counsel in the courtroom in Israel, Cypress, Mexico, in was surprised.
Paraguay, Brazil. So I’m pretty ready for any hook somebody’s The court found that while New Balance had terminated its
going to throw at me.” licenses with Chang’s Hong Kong operating company, it had
China’s intellectual-property laws are actually pretty good, failed to do so with respect to Chang’s Yang Jiang factory. And
Lewin explains. They were upgraded as a condition of its acces- though that factory was never licensed to distribute New Balance
sion to the World Trade Organization in 2001. But the chal- shoes, the court found that its license to make shoes carried an
lenges of litigating in China have “nothing to do with the law as implied license to distribute—and even a right to do so without
written,” he says. “They have much to do with the law as applied.” paying any royalties.
China’s courts are a product of some extraordinary recent his- Lewin considered the court’s reasoning so implausible that he
tory. In the late 1950s, Chinese lawyers were denounced as “right- suspected corruption, he admits. He appealed to the Guangdong
ists” and began fleeing the profession. From 1966 to 1976, during province High Court. The High Court heard the case during the
the Cultural Revolution, the nation’s legal system was abolished, summer of 2002. Then Lewin heard nothing for many months.
its law schools shuttered, and its remaining lawyers sent to the Eventually he hired an investigator to make inquiries. Finally word
countryside for reeducation through labor. The nation’s current came back through two intermediaries: “For $300,000 we could
legal system has been entirely rebuilt since 1979, and it bears some have our decision,” Lewin says.
scars. Most of the older judges are not lawyers, for instance, but FEEDBACK rparloff@fortunemail.com
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THIRD SHIFT
“We were on the head of a pin,” he recalls. “Clearly we weren’t collected a penny; it’s still hunting for assets in Chang’s name.
going to do it. But you’re being asked directly by the tribunal In January 2005 the Guangdong High Court finally ruled. It
hearing your case.” As politely as he could, he responded that, affirmed Chang’s victory. The court did throw New Balance one
no, New Balance really couldn’t do anything like that. bone, finding that the company had terminated the Yang Jiang
More weeks passed. Lewin made more inquiries. Word came factory’s license as of July 27, 2001—19 months after it thought
back again. “The price was down to a hundred grand,” he says. it had. (The termination had been effected, the court said, by a
“As God is my witness.” New Balance again refused. letter to the factory to which New Balance had attached no legal
Still more time passed. In September 2003 the lead judge on significance at the time.) But the belated termination afforded
the three-judge panel contacted New Balance through a differ- New Balance no real benefit. The Chinese IP authorities inter-
ent intermediary. He asked for $100,000 again, and then came preted the ruling as permitting shoes made before that date to
down to $50,000, according to Lewin. This time New Balance still be sold. Accordingly, they released tens of thousands of pairs
of previously seized shoes to Chang, who dumped them on the
market—to the chagrin of New Balance’s new licensed Chi-
“TO INTERPRET AN nese distributor.
AMERICAN COMPANY— In late spring 2005, New Balance petitioned for a rehearing. It
heard nothing for almost a year. Then, on March 28, 2006, out of
HOW WE THINK, HOW the blue, the court granted the petition. The reargument was
scheduled for April 24.
WE OPERATE—THAT’S The case is almost moot at this point, since only a small num-
ber of Chang’s New Balance shoes are still on sale. Haddad be-
REALLY DISTURBING.” lieves that Chang no longer makes them and that he’s focused on
his Henkee brand instead. New Balance has petitioned China’s
trademark office to cancel Chang’s distorted-Hi logo, but other-
wise it left that brand alone.
Today the company has a more pressing concern: a competi-
tor that launched in 2005 under the brand name New Barlun.
New Barlun uses packaging, logos, store displays, and slick ad-
vertising brochures that by Western standards are audacious
ripoffs of New Balance’s. “We have counterfeits all the time,”
comments Haddad. “That’s not anything new. But to interpret
an American company—how we think, how we operate—that’s
what’s really disturbing us.” However, as often happens once a
company has experienced an IP leak, New Balance executives
don’t know whether the New Barlun knockoff has any relation-
ship to its earlier problems or is a completely reverse-engineered
operation—albeit a diabolically sophisticated one. Some New
Next-generation knockoff New Barlun, introduced in 2005, even Balance officials have their suspicions. “They know our com-
mimics New Balance marketing: genuine article (left) and takeoff. pany so well,” Haddad marvels.
Despite all the challenges, New Balance has never considered
reported the request to the province’s supervisory bureau for withdrawing its factories from China. The economic allure is too
courts. In April 2004, after no action had been taken, New Bal- compelling, and as Haddad points out, its products would have
ance formally petitioned the court to replace the judge, though been counterfeited in China to some degree no matter where
without stating the reason. A few days later the judge was re- the company made them. Like others with experience in Asia,
moved from the case (but not from the bench). No explanation New Balance monitors its supply chain to the extent it can,
was given. (Asked about Lewin’s allegations by phone, the re- checks out contractors in advance, writes tough audit clauses
placed judge told FORTUNE, “That’s impossible. Are you in- into contracts, and enforces them. It now embeds encrypted in-
terviewing me? You cannot interview me like this,” and hung formation in security tags and monitors the number of tags it
up. In response to a letter outlining the accusations, a court pub- issues to combat third shifts. Other companies use invisible inks
lic affairs staffer said foreign media had to direct inquiries to the and dyes both to authenticate their products and to trace diver-
Foreign Ministry.) sions from authorized distribution channels. The GenuOne com-
We don’t need to speculate about the way a Western judge pany in Boston even sells software that lets brand owners dis-
might have viewed the same facts, because in 2004 one did. Af- creetly monitor how many tagged components a contractor
ter New Balance invoked its arbitration clause, international ar- orders: If too few, the contractor may be substituting inferior
biter Natasha Lisman, an American litigator in Boston, found the parts; if too many, there might be a third shift.
evidence “clear and persuasive” that Chang had sold at least “If you don’t do your upfront due diligence in managing the
200,000 pairs of New Balance shoes after termination of his con- supply chain,” advises Haddad, “you’re just going to be subject to
tracts. (Chang’s marketing of Henkees also violated a noncom- problems.” But after a pause, he adds a weary coda: “Not that you
petition clause in the contract, Lisman ruled.) In December 2004 won’t be even then.” F
she awarded New Balance $9.9 million. So far, New Balance hasn’t With additional reporting by Clay Chandler and Alice Fung
116 • F O R T U N E May 1, 2006